Monetary policy refers to the macroeconomic policy as defined by the central bank of a state. It consists of management of money supply and of interest rates. With its help, the Central bank increases or decreases the amount of money/currency in circulation around the state at any given time. Similarly, The RBI uses monetary policy to secure economic objectives such as inflation, consumption, growth and liquidity. For example, buying or selling of government securities through open market operations. The principal objective of monetary policy is to reach and maintain a low and stable inflation rate, and to secure a long-term GDP growth trend. It also aims to generate more employment. There are two types of monetary policies-
1) Contractionary monetary policy
It is used to decrease the amount of money flowing through the economy. It can be achieved by selling government bonds or by raising the interest rates.
2) Expansionary monetary policy
It is used to increase the amount of money supply in the economy. It can be achieved by such actions as decreasing interest rates or by the purchase of government securities by the central banks.
Monetary policy is implemented by the usage of monetary policy tools of the RBI. The three main policy tools are:
a) Repo rate (policy rate) - In India, the commercial banks can borrow funds from The RBI if they have a temporary deficit in their reserves. The rate at which the banks borrow reserves from the central banks is referred to as the discount rate. For the Reserve Bank of India, it is called the repo rate. The central bank purchases securities from the other banks that in turn, agree to repurchase these securities at a higher price later. The difference between the repurchase price and the purchase price is the rate at which the central banks lend to the other banks. A lower repo rate encourages lending and decreases the interest rates. A higher repo rate has the opposite effect, it decreases lending and increases the interest rate.
b) Reserve requirements – It refers to the percentage of deposits that the banks are required to maintain as reserves with the central bank. By increasing this percentage, the central bank constructively decreases the funds that are available for lending and the flow of money supply, which would increase the interest rates. A decrease in the reserve requirement will increase the funds that are available for lending and money supply, which will lower the interest rates.
c) Open market operations – The process of buying and selling of securities by the central bank is referred to as open market operations. Buying of securities by the central banks makes more funds available for lending. The money supply increases and the interest rates tend to decrease. The sale of securities by the central banks has the opposite effect. It reduces the amount of funds available for lending and the money supply which increases the interest rates.
Changes in the monetary policy can also affect economic growth, inflation, interest rates and the foreign exchange rates. The effects of a shift toward an expansionary monetary policy include:-
- The buying of securities by the central bank increases the cash reserves.
- Banks become more willing to lend reserves to one another which leads to a decrease in the rate of interbank lending.
- Long-term interest rates tend to decrease.
- The decrease in long-term interest rates leads to increased levels of business investment in plants and equipment.
- The decrease in long-term interest rates also causes the currency to depreciate in the foreign exchange market.
- Lower interest rates increase the purchasing power of people significantly.
- Depreciation of currency results in an increased foreign demand for domestic goods.
- Increases in consumption, investment, and exports increase aggregate demand.
- An increase in aggregate demand increases inflation, employment and the GDP rate.